Tech IPOs are back in a big way. As Wall Street eagerly awaits Facebook’s IPO, recent issuances such as Brightcove, ExactTarget, Vocera (in which GGV is an investor), Millennial Media and Infoblox have been warmly received by public investors, and last week’s IPO of Splunk hit a rarely seen milestone, with shares more than doubling from the IPO price on its first day of trading.

How can a deal like Splunk close its first day of trading so far above its initial filing range? While the bankers on the deal may have believed that the initial filing range would prove conservative, and perhaps the most optimistic may have even thought it possible that the company would eventually price its IPO 89% above the mid-point of the initial range, it’s hard to believe anyone would have guessed the market would value the company at over $3 billion, nearly 400% above the initial filing range at its first day close price.

So, how did this happen? What are the forces at work that drive this type of outcome?

To answer this, I consulted with Ted Tobiason, Managing Director at Deutsche Bank. Ted runs technology Equity Capital Markets at Deutsche Bank and has a wealth of experience with IPO issuances. Ted did not work on the Splunk IPO but he has experience as a banker and an investor (buyer and seller) of tech IPOs that spans 16 years. Ted highlighted two types of investors who often end up buying the shares in hot IPOs on the first day or two of trading:

Fund Managers with Big Funds. Often a big driver for hot IPOs are long-term oriented fund managers with large funds. These players get large allocations of stock in IPOs but need to accumulate substantially more stock to build meaningful positions for their funds. Trading volume is highest on the first day or two of trading. It’s not uncommon, in fact, to see 2-3 times the number of shares sold in the IPO trade hands on the first day of trading (meaning some shares are bought and sold multiple times that day). Volume then tends to steadily dwindle after the first day or two of trading, so if a big fund manager wants to build a large position, heavy buying in those first few days is critical. Large fund managers look at their full positions on an average cost basis, and since they get IPO allocations, their average price will end up well below the first day closing price. These fund managers may not expect much, if any, stock price appreciation from the first day close of a hot IPO to 6 and 12 months hence, but they buy anyway with a longer term outlook.

Momentum Buyers. These investors come in all shapes and sizes – hedge funds, day traders and retail buyers all often act as momentum players. These investors often have no model built, and their investing theses can be based on business, sentiment and/or stock momentum. Their investing timeline is often short and can include those looking for intraday profits as well as those with outlooks measured in a quarter or two. As a result, valuation metrics don’t mean much to this class of investor. Nimble traders may try to play the first few days of heavy volume to profit off the volatility.

As momentum buyers exit the scene and trading volume dwindles, it’s not uncommon to see deals with big first day moves trade poorly over the next 6-12 months. Ted recently published a very interesting chart on this topic detailing the 180-day aftermarket performance of recent tech IPOs (180 days being an important milestone since this is when lockups typically expire). Of the 7 recent tech IPOs whose first day close price was up 50% or greater from IPO price (i.e, the really hot IPOs), only one was above that price 180 days later. In fact, based on this data, investors in the open market would have done better avoiding the hot IPOs and instead investing in the class of IPOs who saw more modest (0-50%) first day gains.

What Does This Mean for Entrepreneurs?

Given these dynamics, Ted has some great advice for entrepreneurs who are readying for an IPO:

Set Appropriate Expectations on the IPO Roadshow. Even if you’re hitting the market at a propitious time with the wind at your back and big macro stories in your favor (such as the emergence of the “Big Data” trend for Splunk), do your best to keep hype out of your story by setting reasonable expectations for investors on growth, profitability and other key metrics. Provide enough information to investors so that they clearly understand the opportunity and your prospects. This will help price discovery and match expectations to valuations.

Drive For a Solid Investor Book. You’ll do yourself a big favor by trying to fill the IPO book with buyers who have done lots of work, know the story and have a long term view on it. These players are far more likely to build a position in the aftermarket and hold it, which is healthier in the long term. This may mean that you end up pricing your IPO slightly below (perhaps as much as $1-2/share) than where you could otherwise do it, but if this attracts the best public investors, it’s a good trade-off.

Although the press and social media outlets pay lots of attention to hot IPOs, the far more meaningful moments for entrepreneurs and VCs don’t come until lock-ups come off and volumes allow for more liquid trading, at least 180 days after IPOs. Maximizing the outcome for this timeframe involves great business execution and continued investor expectation management far more than it relies on having a hot IPO. As Ted reminds us: “First day blow-outs don’t guarantee future success.”

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